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The “future of retirement” seems very much on the public’s mind. The topic is surfacing in the press, in the institutional marketplace, and will be the focus of a Washington, D.C., policy forum I’m attending in May. Here are some of my thoughts. I welcome your comments and will try to incorporate them in my upcoming discussions.

It’s very clear that there is a future for retirement. But to me, it’s really a tale of two futures: the future of retirement income, and the future of retirement health benefits.

Retirement income

Financing a retirement income is essentially a problem of compound interest. The income you generate (whether you’re participating in a traditional pension plan or are contributing to a 401(k)-type plan) is a function of how much you or your employer contributes, over how long a period these contributions are made (namely, how long you work), plus investment earnings.

For a brief moment in time, a series of exceptional factors made these compounding calculations relatively effortless. An expanding workforce made it easy to finance traditional defined benefit (DB) pensions, as well as expanded Social Security benefits. For both DB and 401(k) plans, a spectacular market in equities and bonds in the 1980s and 1990s acted as a rising tide that lifted all boats. At the same time, the age of retirement continued to fall. These factors partially hid the fact that, as a result of gains in longevity, Americans were actually living longer, and so would need more money to finance their retirement standard of living. But it was easy to overlook this fact in the buoyant years.

Now, the demographics are reversing, and we have been reminded that equity or bond markets don’t always generate high double-digit returns. As a result, the trend of increased longevity has become ever more apparent. It is clear that we need more money to finance that longer period of leisure we call retirement.

When you look across the U.S. economy, there are retirement systems that have generally gotten the compounding interest calculations right, despite the seductive demographic and market trends. These are the well-funded private- and public-sector DB pensions, as well as 401(k)-type plans with high average balances. Then there are the laggards—poorly funded DB plans, both corporate- and public-sector, as well as 401(k) plans with low balances. The main difference, it seems to me, is that the successful plans (and successful households) never forget the importance of ongoing and strong contributions.

This is what the angst is all about when we talk about the “future of retirement.” The future of retirement income in America is really about a psychological adjustment to a more realistic set of compound interest calculations. For those with poorly funded retirement plans, the required adjustment can be summed up with just one word: “more.” More resources are needed in retirement—whether from saving at a higher rate, working longer, or a combination of the two.

Retirement health benefits

Retirement health benefits are not readily addressed by the mathematics of compound interest. First, there is the demographic headwind in health care: Unlike retirement income, which is generally lower than during the working years, health costs increase substantially as we age. In other words, you generally spend more on health care in your 60s than in your 50s, and in your 70s than in your 60s, and so forth.

Second, due to a boom in medical technology, health care costs are rising rapidly across the entire economy, both for workers and retirees, at rates like 8–12% per year. If you’re setting aside money for retirement health expenses, there is no natural investment vehicle for your savings that steadily earns 8–12% per year. (If there is, I’ll take two!) Given rapid health care inflation, your existing savings fall behind when they fail to grow at a high rate each year.

Today, there is much discussion about how retirement health benefits should be financed, and how budget reductions might affect Medicare (covering hospital, doctor, and drug costs) and Medicaid (covering long-term nursing care). While the financing issue is important, the real issue to me is the underlying demand for medical care itself. The increase in medical costs starts in the doctor’s office or in the hospital, when your doctor’s evaluation leads to a series of new tests, procedures, drugs, or other treatments for your condition.

Slowing the growth in retirement health care costs is, in the end, about slowing the growth in medical treatments and procedures. When they prepare long-term forecasts of retirement health costs, government and private economists implicitly assume a certain number of medical treatments for each of us from the time we retire to the time we depart this vale of tears. Part of “bending the cost curve” is about slowing this implicit growth rate—i.e., using fewer medical services than projected.

By the way, this doesn’t actually mean spending fewer dollars on health care. Even if we reduce the number of medical interventions per person, the aging of baby boomers means that health spending in total dollars will likely continue to rise. Getting by on less also doesn’t mean the end of technological innovation either. As I described it once to a health policy analyst, it’s about a world where instead of 10 blockbuster medical treatments in the coming decade, we discover only 5—and are happy with that.

Choosing the future

So is there a future for retirement?

The answer is most definitely yes—if we save more and work longer, and accept fewer medical interventions in the latter years of life. The answer is likely no, however, if we continue to believe that retirement means an “early out” package in your mid-50s, along with health benefits to pay for pretty much any new medical technology that comes down the road.

The latter option being financially unsustainable, it seems clear that the former is the only path forward.

Like this:

Steve Utkus

Steve Utkus oversees the Vanguard Center for Retirement Research, which studies many aspects of retirement in America—from how individuals start saving and investing in the early part of their careers, to how they prepare for actual retirement, to how they spend down their savings once they’re retired.
Steve is particularly interested in behavioral finance—the study of how rational decision-making is influenced by human psychology. His current research interests also include the ways employers design retirement programs, and new developments in retirement in other countries.
Steve holds a B.S. from the Massachusetts Institute of Technology and an M.B.A. from the University of Pennsylvania's Wharton School. He began working at Vanguard in 1987 and has served as director of the Center for Retirement Research since 2001. Steve is also a visiting scholar at the Wharton School.

Comments

Anonymous | July 14, 2011 10:04 am

The answer to the high medical costs will be a private-executed system of managed care that is universally underwritten by the federal governemnt.
Managed competition between health-care providers of different states that are sponsored by a regional healthcare underwriter (The Federal Government). Tort reform to cap excessive medical-to- legal expenses.
Have the younger contribute to a universal policy to help fund older medical expenses. Let the care be managed & the execution system of the payment by the private insurance companies.
Allow Doctors to be compensated fairly for their expertise & time. The incentives to be a good Doctor and be $$$ rewarded should be there in the form of Bonuses as well as salaries. Leverage new technologies that are patient-centric first and cost-centric second–balance costs vs treatments over time. These are only a few reforms– they need to be phased-in gradually over a 5-10 period of time. The real challenges will be “How to maintain and improve on the quality of medicine while reducing rising costs of medicine. This will require the cooperation and coordination of both goverment and private medicine/doctors & hospitals and private medical insurers.

Anonymous | July 9, 2011 10:55 am

Unfortunately, many of the doctors’ decisions about which tests to use or not use are driven not by medical diagnosis but rather by the trial lawyers (did you do everything possible to save my clients *******?) and insurance companies (we’re not paying for procedure ‘x’ which is what your patient needs because of *******, but we will cover procedure ‘y’.). This, combined with the insurance companies and the governments “schedule of payments” (we understand that this test cost $xxxx, but we’re only going to pay you $yyyy for it.) has driven many professionals out of the business of being a doctor. Those that remain are forced to charge more to cover not only their actual expenses but also the many possible ‘what-ifs’ of their profession.

Anonymous | July 9, 2011 9:18 am

Many good comments, each made from different life situations. However, generations differ in so many ways dealing with their lives. I believe the government needs to operate within their budget and do not bailout big companies that failed to do so. Most americans live within their budgets, those that don’t will end up in the train wreck and need to learn from their mistakes. Today, people who live within their budgets and do what is right suffer from those that don’t. Congress and senators are exempt from laws they pass for us. People who have great jobs can walk away from their homes or short sale homes even though they can afford them. Which drive up debt to all..Don’t see a light at the end of the tunnel at present..We set back and watch, nothing more, nothing less, as others argue, knowing what the problems are in gov spending and how to solve them, problem is who might suffer the worst on things they promised to very large supporters to get them in office. Again we can only solve this by choosing new people to run the government, not by party, but those americans willing take care of We the people. You know as well as I do, government has very much waste and could be eliminated. God Bless us all, and guide those that are in control of our country at present..

Anonymous | July 8, 2011 8:44 am

I have never understood the idea concerning for-profit health care systems. How do you develop a system that allows you to make money off of someone else’s misery? We are the only country in the free industrialized world that believes in this philosophy.
I am also tired of hearing the pathetic excuse that doctors spend so much time learning and they have the potential of saving people’s lives. Give me a break !!! You deserve better than a nurse, a police officer an EMT, a scientist who discovers a new drug?? Get over yourself. You’re body mechanics. If you don’t feel you get adequate pay LEAVE THE PROFESSION. Leave it to people who belive the the philosphy of do no harm and care about their fellow man. I no of no current profession that has not taken a hitexcept the medical profession. I find our costs to be the worst in the world for only adequate quality of care at best.
I toltally agree that medical care cost will be our downfall and until the medical industry and medical insurance are brought under consideral control they will destroy our economy.

Anonymous | July 4, 2011 9:43 pm

Anonymous | July 3, 2011 11:44 pm

Article encouraged me not only to ponder, but act upon…upping my 401-K to 25% today. If I watch what I spend and be “smarter” rather than “smart-enough,” I can do this (i.e., don’t let your kind, more humane self overpower your common-sense-persona when a neighbor asks you to help lift something, and you want to help so bad you forget you had back surgery five years ago and ignore that tingling down your leg…be smarter, and say you can’t, and why if they go, “harumph!”) And I do support a regular check-up; the person who realized that the cost of an annual isn’t nearly as expensive as not having an annual exam is on the right track. This includes dental exams. My dental plan covers 3 a year; I pay for a 4th and go every 3 months for a cleaning and exam. Maintaining your health is the first step in keeping the bills down, and we can all do our part. Do we really need to have people out there that continue to smoke or are morbidly overweight because they cannot control themselves (do we really understand how much their weakness contributes to the high medical costs)? I don’t think so, because if we were all paying attention we’d be out there with pitchforks seriously protesting the fast food and tobacco industries…but we don’t. Oh, I forgot. The right to a “choice.”

Anonymous | July 1, 2011 11:06 pm

Anonymous | July 1, 2011 3:04 am

My thoughts are that health insurance & health care are now harder to fund than retirement itself. The costs of the insurance or paying for care yourself are overwhelming. Sometimes people can’t afford to pay their doctor bills because of the high insurance premiums they pay. I believe that we need to try universal health care. Most of us pay into the health care system via insurance premiums. So we already pay. If you no longer pay the insurance premium but pay for the universal health care thru taxes what is the difference? And, if you become unable to pay into the system at least you won’t go without coverage. Don’t mandate everybody have insurance, rather enroll everybody in the program from birth. As soon as you can work or have an income (even if it’s welfare) you start paying into it. Yes, more people will access health care but isn’t that better rather than rationing by ability to pay? And we won’t have a zillion insurance companies to deal with. Only one. One set of forms. One contact for the providers to deal with. Thats a book-keeping savings all by itself. Loose the medicare and all the other special programs for kids etc that are administered separately. If we do this then maybe we can get back to planning our retirements on more realistic terms.

Anonymous | June 24, 2011 1:51 pm

First, let me say thank you to Mr.Utkus for clarifying that there are two retirement areas (health benefits & income) that should be highlighted for discussion. The inelastic demand that exist in our health care needs to be addressed so that Americans can understand the true cost.

Secondly, once those cost are really identified and itemized people can then factor that against a budget that sets aside savings for retirement. I can honestly say I have not read a more simple analysis of the issues. Do your best to control your health expenses, plan on saving more and working a little longer.

In the end being educated about what you as a consumer can do to have a retirement is the key. Educate yourself on health related issues and ask questions of your doctor, including the cost and the do I really need this. Get second opinions about both your health and if your saving enough to meet your retirement goals. Besides, if your healthy you may want to work a little longer anyways, especially if you enjoy the work.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.